Is idiosyncratic tail risk priced in the cross-section of bond returns? –Evidence from Chinese bond markets

ABSTRACT

This article investigates for the first time the role of idiosyncratic tail risk in the cross-sectional pricing of bond returns. We use the idiosyncratic return of the bond to measure the idiosyncratic tail risk based on the extreme value theory. The results show that bonds in the highest idiosyncratic tail risk quintile generate 3.5% more annual return compared to bonds in the lowest idiosyncratic tail risk quintile. In addition, we found that idiosyncratic tail risk is cross-sectionally positive correlated with bond expected returns in Chinese bond market, even when the downside risk, bond rating, liquidity, size, maturity, bond market beta, short-term reversals, and coupon rate are controlled. The positive correlation is in line with the traditional risk-return tradeoff theory. Because of their aversion to extreme losses, investors are willing to accept the low returns from low idiosyncratic tail risk bonds.

KEYWORDS:

• Idiosyncratic tail risk
• extreme value theory
• bond markets
• return predictability

JEL CLASSIFICATION:

• G12
• G11

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ The CSMAR(China Stock Market & Accounting Research) research database is the market leader in China’s financial data services industry.

² PSLIQ is the Pastor-Stambaugh liquidity measure, Amihud is the Amihud illiquidity measure (Lin, Wang, and Wu 2011).

³ We obtained similar results (see Table A1) by calculating equal-weighted portfolio returns and alphas.

⁴ The ten factors are constructed following Bai, Bali, and Wen (2019, 2021).

⁵ We obtained similar results (see Table A2) when using bivariate equal-weighted portfolio analysis.

⁶ The results are shown in Tables A3 and A4.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [No. 72171039; 71771042], and the Project of Humanities and Social Science of Ministry of Education of China [Grant No. 18YJCZH224].